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Vol. 6, No. 1
JANUARY 2011­­

EconomicLetter
Insights from the

Federal Reserve Bank of Dall as

With Reforms in China, Time May Correct
U.S. Current Account Imbalance
by Jian Wang

Outside pressure to
appreciate the yuan
could increase China’s
resistance to reforming
exchange rate policy and
financial markets.

T

he U.S. current account deficit has deepened significantly since
the late 1990s. This shortfall—the value of net exports of goods
and services, international financial investment net income and transfer
payments—was $803 billion at its peak in 2006, or 6 percent of U.S. gross
domestic product (GDP). Conversely, China, Germany, Japan and the oilexporting countries have been running current account surpluses that have
risen substantially (Chart 1). This divergence has raised concerns among
policymakers, economic researchers and private investors about whether
these imbalances are sustainable and at what risk to the global economy.
In theory, current account imbalances do not necessarily indicate economic danger. If a country is expected to grow more rapidly in the future,
running a current account deficit is an optimal behavior. The country
should borrow now from the rest of the world to finance current consumption and repay the money later when it has greater means. For instance,
Europe ran a current account deficit while rebuilding after World War II.
A large share of the U.S. current account deficit before 2005 was
with other industrial countries, such as Germany and Japan. This behavior
makes economic sense, argue Charles Engel, a University of Wisconsin–
Madison economics professor, and John Rogers, a Federal Reserve Board
economist.1 These trade deficits/surpluses simply reflect the difference in
growth prospects between the U.S. and other major industrial nations.
Since the mid-1970s, economic expansion in the U.S. has outpaced that of
other industrial countries. GDP on average grew 2.82 percent in the U.S.
between 1975 and 2009, compared with 1.87 percent for Germany and
2.33 percent for Japan. If the U.S. continues to outperform other industrial
countries, it is optimal to borrow from these nations now and incur a

Chart 1

U.S. Current Account Deficit Continues
Dollars (billions)
1,500

Rather than an

1,000

undervalued currency,

500

China’s ballooning current

China
Oil-exporting countries
Japan
Germany
United States
All other countries

0

account surplus may reflect

–500

deeper structural distortions

–1,000

in its economy.
–1,500

’90

’91

’92

’93

’94

’95

’96

’97

’98

’99 ’00

’01

’02

’03

’04

’05

’06

’07

’08

’09

SOURCES: International Monetary Fund; Haver Analytics.

current account deficit. Assuming that
the difference in economic growth
between the U.S. and other industrial countries over the past 30 years
continues for another 20 years, Engel
and Rogers found that a standard economic model could justify a U.S. current account deficit at its 2004 level,
the end of the period covered in their
research.
Demographic differences also factor into account imbalances. The populations of several industrial countries,
including Germany and Japan, are
aging more rapidly than the population
of the U.S. The need to support future
retirees provides an incentive for these
countries to save and incur current
account surpluses with the U.S.
The Role of China’s Yuan
Oil-exporting countries and fastgrowing Asian economies, particularly China, began playing an increasingly important role in global current
account imbalances in 2005. The substantial increase among oil-exporting
countries after 2005 is mainly due to
rising energy prices. China’s current
account surplus rose to $436.1 billion

EconomicLetter 2

Federal Reserve Bank of Dall as

(9.88 percent of GDP) in 2008 from
$68.7 billion (3.55 percent of GDP) in
2004, though the genesis of that gain is
at first glance puzzling.
Normally, a fast-growing economy
such as China would borrow money
from the rest of the world instead of
lending. An obvious suspect in China’s
mounting current account surplus is
the fixed exchange rate between its
yuan and the dollar. An undervalued yuan makes Chinese products
cheaper than those of competitors
in international markets. As a result,
China exports more than it imports.
According to this explanation, yuan
appreciation could rebalance the global economy. This argument has at least
two flaws.
First, the durability of the U.S.–
China imbalance is difficult to explain.
In order for the exchange rate to affect
import prices, those prices can’t adjust.
For instance, assume that the People’s
Bank of China undervalues its currency
10 percent to make Chinese products
10 percent cheaper than they otherwise would be. If Chinese producers
could change their prices immediately,
they would increase prices 10 percent

to offset the undervaluation. Although
in reality prices cannot change instantly, they do adjust over the long run;
therefore, the exchange rate has only
short-term effects on import prices and
the current account. China has run a
significant trade surplus against the
U.S. for about 10 years (Chart 2). It is
hard to imagine that prices have not
fully adjusted to offset the exchange
rate after such a long period.
Second, an appreciating yuan may
only minimally reduce the imbalance.
Even in the short run, the exchange
rate’s impact on import prices would
be quite limited, studies have shown.
Exporters usually pass on only a fraction of exchange rate movements
when setting prices. About 20 percent of exchange rate changes were
reflected in U.S. import prices during the past decade, Federal Reserve
economists Mario Marazzi and Nathan
Sheets found.2 Profit margins usually
absorb some of exchange rate movement as exporters seek to maintain
market share.
Additionally, the currency under
which import prices are invoiced also
affects the exchange rate pass-through.
Most U.S. imports from China are
priced in dollars, and their prices are
fixed in the short run. In this case,
depreciation of the dollar against the
yuan has no short-run effect on import
prices from China.
Effect of Structural Distortion
Rather than an undervalued currency, China’s ballooning current
account surplus may reflect deeper
structural distortions in its economy.
Chart 2 shows that China’s total trade
account balance began to move up in
2005, though the bilateral trade surplus
with the U.S. began much earlier.
High household savings is a
suspected cause of China’s massive
current account surplus. However,
corporate and government savings
have played a more important role
(Chart 3). The amount of household
savings as a percentage of disposable income has been stable since the

Chart 2

China’s Trade Imbalances Persist
Percent of GDP
10

Total trade balance

9

Bilateral trade balance with U.S.

8
7
6
5
4
3
2
1
0

2000

2001

2002

2003

2004

2005

2006

2007

2008

SOURCES: Census Bureau; Haver Analytics.

Chart 3

Corporate and Government Savings Increase in China
Disposable income (percent)
60

Government
Corporate

50

Household

40

30

20

10

0

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

SOURCE: People’s Bank of China.

1990s, although the savings rate is high
relative to that of industrial countries.
Corporate and government savings
have increased substantially compared
with the household rate since 2004—
when the current account surplus
began expanding.

Federal Reserve Bank of Dall as

The corporate and government
savings increases were accompanied
by a shift in the composition of stateowned enterprises. During this period,
state-owned corporations exited from
industries with low profit margins, such
as textiles. Meanwhile, state-owned

3 EconomicLetter

EconomicLetter
corporations continue to dominate
and crowd out private companies in
industries with higher margins, such as
finance, energy, telecommunications,
transportation and real estate. This
leadership of state-owned corporations
is not a result of market-based competition. Instead, it is a product of favorable government treatment, including
easy access to credit and advantageous
loan terms from state-owned banks.
The government also erected policy
barriers to prevent private entry into
these industries.
The booming global economy
around 2005 boosted China’s corporate
profits. Earnings in the high-margin
industries were transformed into savings because the government lacked
channels to redistribute them for
household consumption. In the long
run, this structural economic distortion
should be corrected to balance China’s
current account surplus. Financialsector reform and removal of entry
barriers in industries dominated by
state enterprises will decrease the corporate savings rate. Authorities should
also increase competition in these now
highly regulated industries, promoting
efficiency and economic growth in the
long run.

China also recently passed the Social
Insurance Law, laying the foundations
for its social safety net. Social welfare
programs such as retirement, basic
health care and unemployment insurance coverage will be created. Such
programs have been difficult to establish in China in the past.
Structural changes will require
time to implement, and the current
account imbalance between China
and the U.S. may continue. Policies
attempting a quick fix may produce
unintended consequences. Outside
pressure to appreciate the yuan could
increase China’s resistance to reforming exchange rate policy and financial
markets—both crucial to addressing
this massive country’s structural
economic issues.
Wang is a senior research economist in the
Globalization and Monetary Policy Institute at
the Federal Reserve Bank of Dallas.
Notes
The author thanks Payton Odom for his research
assistance.
1

See “The U.S. Current Account Deficit and the

Expected Share of World Output,” by Charles
Engel and John H. Rogers, Journal of Monetary
Economics, vol. 53, no. 5, 2006, pp. 1063–93.
2

Steps to Balance Economy
In the shorter term, boosting government spending on the social safety
net may effectively reduce China’s current account surplus. Increasing such
expenditures not only can directly
decrease government savings but also
reduce overall household savings
through shared risk.
The Chinese government has officially acknowledged a need to balance
its economy, listing increased domestic
spending as one of the most important issues in its 12th Five-Year Plan
(2011–15). Yi Gang, deputy governor
of the People’s Bank of China, said
in October that China would reduce
its current account surplus to less
than 4 percent of GDP within three to
five years—a target proposed by U.S.
Treasury Secretary Timothy Geithner.3

is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy is provided to the
Research Department of the Federal Reserve Bank of
Dallas.
Economic Letter is available free of charge
by writing the Public Affairs Department, Federal
Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX
75265-5906; by fax at 214-922-5268; or by telephone
at 214-922-5254. This publication is available on the
Dallas Fed website, www.dallasfed.org.

See “Declining Exchange Rate Pass-Through to

U.S. Import Prices: The Potential Role of Global
Factors,” by Mario Marazzi and Nathan Sheets,
Journal of International Money and Finance,
vol. 26, no. 6, 2007, pp. 924–47. Marazzi later
became executive director of the Puerto Rico
Statistics Institute.
3

See “China to Cut Current Account Surplus

Through Gradual Adjustment, Yi Says,” by Ye Xie,
Bloomberg, Oct. 9, 2010.

Richard W. Fisher
President and Chief Executive Officer
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